Default Looming, Rating Agencies Sound The Alarm

President Obama has endorsed a plan from the Senate's bipartisan "Gang of Six" that would shave nearly $4 trillion off the deficit over the next 10 years.

The major credit rating agencies have warned that the government needs at least that level of deficit reduction to preserve its top-notch bond rating. It's a powerful message from the rating agencies, which were largely discredited in the years leading up to the financial crisis.

Defaults Driven By Politics

A credit rating is a kind of report card that tells investors how likely they are to be repaid when they lend money to a corporation or the government. Nikola Swann develops those report cards for one of the big rating agencies, Standard & Poor's. Because Swann rates government bonds, he has to count not just dollars in the Treasury, but also votes in the House and Senate.

"We do have to take into account the politics. The fact is, a very large number of sovereign defaults that have happened have been directly driven by the politics," he says.

Last week, S&P and its ratings rival Moody's both issued warnings that the U.S. government's rock-solid guarantee of repayment might not be so rock-solid after all.

Both cited the possibility that lawmakers will not vote to raise the government's debt limit in time to avoid a default.

But Swann says that's not his biggest concern. He says the real danger is that after all this talk about getting the government's fiscal house in order, policymakers won't grab the opportunity to make tough, long-term decisions to rein in the deficit.

"So if that consensus cannot be reached under these conditions," Swann says, "it does bring up the question of what conditions could they be reached under."

That assessment has strengthened the hand of people in both parties who are pushing for large-scale deficit reduction. Treasury Secretary Timothy Geithner invoked the rating agencies during closed-door negotiations at the White House last week. And Texas Rep. Jeb Hensarling quoted from a ratings report during a Republican news conference.

"Rough translation: There is no more road left to kick the can down the road."

S&P does not take a position on what mix of spending cuts or tax increases might achieve its deficit-cutting target. But Swann says that in order for any plan to be believable, it will have to survive through several different election cycles.

"So for that to happen, we believe you would have to have the leadership of both parties agree to the plan," he says.

That suggests that the plan can't be tilted too much one way or another. "Well," Swann adds, "it has to be a compromise."

'Nobody Likes Them'

In a sense, the rating agencies are merely stating the obvious. But the obvious carries extra weight when they say it. Amy Borrus, who's with the Council of Institutional Investors, can only shake her head at the attention paid to the rating agencies, given their track record over the past decade.

"It's been, in a word, pretty poor," she says. "You know, 10 years ago they failed to see the collapse of Enron coming around the corner. In the global financial crisis ... there were many instances where credit raters inflated ratings on structured financial products to win business from firms that issued the debt."

That's been one of the problems with rating agencies: They're typically paid by the companies or governments whose debt they're rating — a system that's been likened to having food critics paid by the restaurants they're reviewing.

Bob Dannhauser, who's with a professional group of investment pros called the CFA Institute, says one of the goals of the Dodd-Frank financial overhaul was to limit the influence of rating agencies as the sole arbiters of credit-worthiness.

"They're unusual in Washington these days, in that nobody likes them," Dannhauser says. "Nobody's standing up for them. They're sort of a universally disliked target. And that was heard loud and clear as Dodd-Frank got negotiated and passed."

So far, though, no clear alternative to the rating agencies has emerged. And Dannhauser thinks that in the current debate over deficits, they're actually performing a valuable service.

"One of the criticisms of credit rating agencies is that they're always a little bit late to the party," he says. "They issue downgrades after the market has absorbed and digested all the bad news there is to have. This is a pretty good example of them trying to be in front of the issue and say, 'Here's the path that we're on, and look out.' "

S&P's Swann says that warning is really directed at investors, not the government. But as U.S. policymakers decide what to do next, some will be thinking about how this will look on the country's financial report card.